One part about financial ‘innovation’ that isn’t always brought up is the fee churn factor in innovation. Here’s Joe Stiglitz, Senior Fellow at the Roosevelt Institute (which is rad), here, with this great quote about what constitutes financial innovation:

There are alternatives out there. They could have done it right. The Danish mortgage bonds system, there are other mortgage products out there. But they did not generate the fees that have motivated the industry. And it goes back to the fundamental problem that I mentioned in the beginning of failure of alignment between private rewards and social returns. When I was on the council of economic advisors I saw that not only was the financial sector not innovative, they resisted our innovation. We came up with this idea of having inflation indexed bonds, and it was initially resisted by treasury, resisted by the financial markets. I scratched my head and I asked why. And then we figured out why. People buy these products and hold them to retirement. If you hold them to retirement you don’t make fees, because you don’t have people selling and buying them. And so for the financial sector they were disastrous. For Americans worried about the risk of inflation, they were a fantastic product.

I love that. The most innovative product for a financial firm is one that always has volume and, sometimes, always has volatility. Many investors would prefer neither, they would prefer their investments boring. So there’s a clash here.

As you can see, the main revenue sources would be in stocks, bonds and swaps. Even if trading is cut in half, the tax still raises $176.9 billion a year, which would make it the federal government’s third-largest revenue stream after individual income and payroll taxes (see Table 1-8 in the CBO’s FY2011 budget analysis).

How much trading would actually be affected is an open question; the authors have in the past called (PDF) a 25 percent drop “implausibly high,” suggesting that the probable revenue would be somewhere between $353.8 billion (the figure for no drop in trading) and $265.3 billion (the figure for a 25 percent drop). Proponents hope that at least some meaningful drop in trading would occur. One point of the tax is to deter high-frequency trading and to reduce the size of the financial services industry, which would not be accomplished if trading does not fall. There’s thus a trade-off between the revenue gains to be had from an FTT and the size of its effect on the financial sector.

In any case, an FTT would produce far more revenue than alternative taxes on the banking sector. A new Institute for Policy Studies paper, set to be released tomorrow, shows that FTT revenue (as measured in the Baker et. al. paper) pales in comparison to what would be generated by the Obama administration’s proposed bank levy ($9 billion a year) and the IMF’s proposed financial activities tax ($28 billion a year). Of the three, only an FTT would make a big dent in the deficit.

Even a small FTT would cut so much of the churn factor out of the financial markets that can increase volatility or lead people to think they have liquidity in bad times that they in fact don’t. I’m still learning the international experiences with an FTT, and I’ll have more towards the end of the summer. But hitting two birds with one stone strikes me as a good idea here.

2 Responses to The Innovation of Fee Churn, FTT Research Desk Answer

I think it’s safe to say that if 70%+ of transactions are HFT, then any sort of FTT would cut transaction levels by at least 70%, since it would remove any expected gain for the HFTs. I’d say overall it would probably be worse than that, more like 80%+. The numbers, 0.5% on stock trades, 0.01% on FX trades, 0.01% on bonds and swaps and 0.02% on futures, sound small, but in fact they are huge when you consider that a swap of $1bio is relatively common. Yet another example of people from outside of an industry looking in and unilaterally coming up with ideas, which in practice are utterly ridiculous.

The numbers that Klein comes up with as revenues are huge. Here’s a hint, if something is too good to be true, it usually is.